41 lines
2.8 KiB
Plaintext
41 lines
2.8 KiB
Plaintext
Chapter 13: Reverse Spreads
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Buy 2 July 45 calls at 1 each
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Sell 1 July 40 call at 4
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Net
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2 debit
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4 credit
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2 credit
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233
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These spreads are generally established for credits. In fact, if the spread cannot
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be initiated at a credit, it is usually not attractive. If the underlying stock drops in
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price and is below 40 at July expiration, all the calls will expire worthless and the
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strategist will make a profit equal to his initial credit. The maximum downside poten
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tial of the reverse ratio spread is equal to the initial credit received. On the other
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hand, if the stock rallies substantially, the potential upside profits are unlimited, since
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the spreader owns more calls than he is short. Simplistically, the investor is bullish
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and is buying out-of the-money calls but is simultaneously hedging himself by selling
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another call. He can profit if the stock rises in price, as he thought it would, but he
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also profits if the stock collapses and all the calls expire worthless.
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This strategy has limited risk. With most spreads, the maximum loss is attained
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at expiration at the striking price of the purchased call. This is a true statement for
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backspreads.
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Example: IfXYZ is at exactly 45 at July expiration, the July 45 calls will expire worth
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less for a loss of $200 and the July 40 call will have to be bought back for 5 points, a
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$100 loss on that call. The total loss would thus be $300, and this is the most that can
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be lost in this example. If the underlying stock should rally dramatically, this strategy
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has unlimited profit potential, since there are two long calls for each short one. In
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fact, one can always compute the upside break-even point at expiration. That break
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even point happens to be 48 in this example. At 48 at July expiration, each July 45
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call would be worth 3 points, for a net gain of $400 on the two of them. The July 40
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call would be worth 8 with the stock at 48 at expiration, representing a $400 loss on
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that call. Thus, the gain and the loss are offsetting and the spread breaks even, except
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for commissions, at 48 at expiration. If the stock is higher than 48 at July expiration,
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profits will result.
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Table 13-1 and Figure 13-2 depict the potential profits and losses from this
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example of a reverse ratio spread. Note that the profit graph is exactly like the prof
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it graph of a ratio spread that has been rotated around the stock price axis. Refer to
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Figure 11-1 for a graph of the ratio spread. There is actually a range outside of which
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profits can be made - below 42 or above 48 in this example. The maximum loss
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occurs at the striking price of the purchased calls, or 45, at expiration.
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There are no naked calls in this strategy, so the investment is relatively small.
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The strategy is actually a long call added to a bear spread. In this example, the bear |